degrees of freedom: rethinking the …personal.lse.ac.uk/hancke/myweb/hanckegoyer 2004.pdfdegrees of...

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3

Degrees of Freedom: Rethinkingthe Institutional Analysis of

Economic Change

bob hancké and michel goyer

No self-respecting economist, political scientist, or sociologist todayignores the importance of institutions. In standard economics, institu-tional analysis has found a central place: endogenous growth theory,transaction costs economics, as well as the new economics of organiza-tion imply an active incorporation of institutions into theory; andsince the seminal article by March and Olsen (1984), even hard corebehavioural political science has been forced to come to terms withthe structuring effect of institutions, while game-theoretic approachesin political science underscore the role of institutions in shapingoutcome sets.

This chapter builds on and acknowledges these contributions ofinstitutionalism, but is critical of some of its implications for theanalysis of economic change. We agree with the (often unspoken)claim that institutional frameworks preclude certain trajectories ofchange: particular adjustment paths are highly unlikely, and probablyimpossible, because of how they rely on the presence of other elementsin an institutional framework. What we take issue with is a tendency inthis literature to reify institutional frameworks, which runs the risk ofleading to an institutionally determined teleology. Institutional frame-works, we will argue, have the capacity to offer alternative adjustmentpaths that cannot simply be ‘read off’: how actors operate in particu-lar institutional frameworks, and how they ‘learn’ to operate withinit, matters for their effects. Similar institutions can therefore lead to

We would like to thank Richard Bronk, Steven Casper, Scott Cooper, Peer Hull Kristensen,Glenn Morgan, Richard Whitley, and the participants in the Oslo workshop for helpfuldiscussions and comments.

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54 Bob Hancké and Michel Goyer

different outcomes, and institutional frameworks can offer actors newadjustment paths beyond the immediately visible ones.

Our critique addresses both actual and potential problems that wesee with the literature. While many authors are sensitive to the pointswe raise, too often the implications of these points seem to be ignored.Our aim with this chapter is to take stock of this implicit debate withininstitutionalism and use it as a means to improve institutional theory.

The chapter starts by reviewing the standard arguments on insti-tutions and economic change, and then present our alternative view.Section 3.2 presents empirical material on economic adjustment fromFrance and Germany. This suggests that the creative use of elements ofthe institutional frameworks by critical actors, and the re-articulationof existing elements, allowed them to adopt paths that were prob-ably impossible to predict with the use of the conventional views oneconomic adjustment in these countries. Section 3.3 concludes.

3.1. The Contributions and Limits of Institutional Theory

Fromtwodecadesof researchwithin the ‘newinstitutionalism’ inpolit-ical economy, economic sociology, and comparative business studiesa broad consensus is emerging on the relation between institutions,economic action, and economic change. According to this view, insti-tutional frameworks powerfully shape the reaction space of actors in atwo-step process. The first step is related to the role of institutionsin defining the scope and nature of new problems. Since institu-tional frameworks operate as filters for environmental stimuli, actorsperceive similar challenges very differently in differently organizedsocieties (Hall and Soskice 2001; Locke and Thelen 1995). The secondstep deals with the set of possible solutions that actors may perceivefor the problems they identified. Since institutions are logically priorto interests in this view, the formation of preferences by economicactors is an endogenous result of the existing institutional structure(Berger 1982; Hall 1986; Steinmo et al. 1992), and in this process, insti-AQ: Please

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tutions are not neutral (Zysman 1994: 244). In sum, actors pursue theirstrategies in accordance with the definition of both the problems andtheir interests as they have been shaped by the institutional structure.

A classic example of this line of argument is Streeck’s study (1989)on how German and US car producers both faced a crisis in the early1980s, but responded very differently. The German manufacturers,eager to capitalize on the ‘Made in Germany’ label, went up-market,

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Degrees of Freedom 55

while the US producers primarily saw their crisis as a cost crisis, andthus started searching for cost reductions. The German strategy dir-ectly resulted from the constraints imposed by (among other things)the system of labour relations with strong unions at their core, whichprecluded a cost-based strategy, and the ability of these very institu-tions to constructively offer alternative paths; the effect was a move upthe quality scale into less price-sensitive market segments. In contrast,labour law has allowed US producers to de-unionize large parts of theirproduction system, and impose a series of cost savings which oftentook the form of massive workforce reductions in order to competewith Japanese producers on price.

Two related but analytically distinct implications for the analysisof economic action are associated with this view: one is that differentinstitutional frameworks lead to divergence across market economies;the second is that they contribute significantly to maintaining differ-ences across, and continuities within, nations. Both of these outcomesare related to the notion of path dependency, which itself emphasizesthree issues: the importance of starting points, the role of (institu-tional) inefficiencies, and the importance of critical junctures (Deeg,Chapter 2, this volume; Herrigel and Wittke, Chapter 11, this volume).Early events, often of a formative nature, thus have a great influenceon the sequence and character of future events (Pierson 2000: 252). Theimportance of being first is a direct function of the presence of increas-ing returns to scale, the importance of switching costs, and the wayearly events set limits on the range of possible future developments(Arthur 1994; Crouch and Farrell 2002; Pierson 2000). The institutionalstructure of a system of corporate governance, for example, dependson the initial structure in which domestic firms were first embedded(Bebchuk and Roe 1999).

Divergence across nations is a result of institutionally determineddifferences in power relations among actors, privileging some whiledemobilizing others (Hall 1986: 19; Pierson 2000; Steinmo et al. 1992).Institutional frameworks affect the power of actors in several differ-ent ways: their ability to overcome collective action dilemmas, theiraccess to the decision-making process, and the resources at hand. Bystructuring both preferences and power, the institutional frameworkfaced by domestic companies and other actors constitute a ‘matrix ofincentives and constraints that militates toward some kinds of firmbehaviour and away from others’ (Hall 1997: 181).

Finally, the process of institutional formation is critical and infre-quent. There are critical junctures characterized by institutional change

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that send countries, firms, and other actors along different develop-mental paths that are then extremely difficult to reverse (Hall andTaylor 1996: 942; Thelen 1999: 387). The metaphor of the brancheson a tree is insightful. Once you start going down on a particularbranch, other branches down the tree are precluded. Any evalua-tion of this debate has to start by acknowledging how much thisview of institutions and institutional change has helped us in under-standing economic adjustment. In most general terms, it has made usaware of the role of history in defining the range of possible adjust-ment paths (see, for example, Hall 1986; Hall and Soskice 2001;Pierson 1994). It has also allowed us to capture better why someexperiments in institutional reform fail (Levy 1999; Wood 1997), whyeconomic adjustment, including workplace restructuring, took dif-ferent forms in different countries (Streeck 1989, 1996; Turner 1991),and why competitive pressures in international markets have notled to a single sustainable model of capitalism (Hall and Soskice2001). In all these cases, existing institutional frameworks limited therange of options for economic actors, structured their incentives tofavour the initial path, and this was reflected in the differences in theoutcomes.

Yet this position may overstate the power of institutionalframeworks—and therefore of the nature of the constraints that actorsmay perceive. One part of this objection is empirical. Multiple adjust-ment paths and patterns of business organization often coexist withinthe same institutional framework: even among the small group ofOECD countries, there are differences between companies, sectors,and regions within each of the countries. Within German capital-ism, for example, there are many instances of weakly regulatedlabour markets, where the hard codetermination laws that governthe economy in the ideal–typical version found in textbooks do nothold sway, and where primary and secondary working conditionsare set unilaterally (within a minimum legal framework) instead ofnegotiated between strong actors (Hassel 1999; Herrigel and Wittke,Chapter 11, this volume). Conversely, some companies in the UnitedStates have, against the odds, been able to successfully rely on coopera-tive labour relations, shop-floor workers’ participation in self-steeredteams, and strategic comanagement (Rubinstein and Kochan 2001).And the German political economy increasingly accommodates verydifferent models of regional economic development, ranging fromthe symmetric model associated with the south-west of the country(Herrigel 1996), to a considerably more hierarchical model of relations

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between large firms and their suppliers as in the east of the country(Casper 1997).

Are these internal variations just noise, as highly ideal–typical treat-ments of (frequently national) institutional frameworks assume, or isthere a logic to and perhaps a hierarchy among these multiple patterns(Crouch and Farrell 2002)? Rather than treating this as just randomvariation and thus defined away, the first question should be howthese different patterns coexist. Since institutional adaptation ofteninvolves the resuscitation of existing but ignored elements of the dom-inant framework (as in institutional ‘bricolage’ or in the generalizationof what was initially a niche strategy to the rest of the economy—thecase of ‘diversified quality production’ in Germany, as Piore and Sabel(1984) have argued), understanding how these different elements aremutually articulated becomes a necessity for understanding change.

Our final objection to some of the applications of institutionaltheories deals with the question of what to make of paths that wereultimately not chosen. First of all, there is a basic methodologicalissue: how do we know they were not chosen? If choice entails anactive option for one of at least two alternatives, we have to be able todemonstrate that these alternatives were actually there, if only in thesense that they were debated as a possibility. Failure to do so has vastmethodological implications, since it implies that we are unable to dis-tinguish between a lack of (awareness of) alternatives—the operationalopposite of ‘choice’—and choosing a particular option. But even if weassume the existence of alternative paths, the question that needs to beanswered is why these were not chosen when the chance was offered.Is this ‘choice’ (or rather ‘non-choice’) explained by the mechanismsat the heart of the path-dependency argument (positive feedback andswitching costs), or by other, perhaps very different mechanisms suchas sudden exogenously determined reversals in the economic or polit-ical fortunes of some of the actors? Correlation is not causation, aswe never cease to tell our students; yet, when it comes to the institu-tional analysis of economic adjustment, we all too often accept lowerstandards of proof.1

1 Wood (1997) offers a good example of how this should be done. After demonstrating thatthe first Kohl government had a very ambitious agenda in economic policy, which includedtax cuts, a restructuring of key labour market institutions (works councils and training system),privatizations, and deregulation, his analysis shows how and why German employers were veryreluctant to go along with this programme. Their interest was to avoid a complete overhaul of thesystem, especially in labour relations, because it might endanger their product market strategies,which had been highly successful until then. Thus, a coalition emerged, which included theworkers’ wing of the ruling party, employers, and unions, against the (for German standards

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The reaction against these deterministic views of institutions hasappeared in two forms of constructivism. The first is the ‘soft’ con-structivist position that institutions do not solely regulate economicaction, but are elements of a quasi-constitutional order that ‘produces’as much as regulates actors and their outcomes; rather than seeingboth as independent, this view stresses their mutual construction. Thebest examples of this position are found in the literature on compara-tive capitalism, which often started from the deterministic views andthen reintroduced actors in a more dynamic conception. Both Hall andSoskice (2001) and Whitley (1999), for example, demonstrate how thecapabilities and resources that economic actors have at their disposalare a function of the institutional frameworks they find themselves in.

The second form of constructivism establishes a more radical breakwith the prevailing form of institutionalism. It emphasizes strategicaction, and takes that to its logical conclusion: there are, in principle,no limits to the types of solutions that economic actors can bringto bear on problems they identify; indeed, since even the identi-fication and conceptualization of a problem is socially constructed,institutions cannot be assumed to have any fixed quality whatsoever—neither for identifying problems, nor for finding solutions (Sabel andZeitlin 1997). If institutional frameworks matter, it is because they offerelements to construct novel strategies—but these elements are alwayssubject to a protracted process of redefinition and reconstruction, oftenup to the point that they may have little to do with what they wereinitially.

The problem with these constructivist views is that the soft view isnot sufficiently distinct from the deterministic position, whereas theradical one has moved too far in the opposite direction. Regardingactors as constituted by institutions also imputes an institutionallydetermined rationality onto the situation: actors still pursue interests,but these interests are a direct function of the institutional frame-work they find themselves in. This implicit teleology evokes echoes ofWrong’s critique of sociology’s ‘over-socialized conceptions’ of actors(Wrong 1961): actors, either individually or collectively, do think, eval-uate, develop strategies, and act upon these considerations. Treatingeach of these steps in the process as determined by the rules and normsthat govern individuals, groups, and organizations, misses the point

radical) reform proposals, and the reforms died a silent death. Thelen (2000) takes the analysisfurther and demonstrates that parallel strategic considerations were at the basis of Germanemployers’ reluctance to adopt similar (but even more modest) reforms in the mid-1990s.

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that actors can do unexpected things that do not necessarily followdirectly from the institutional framework. Since actors are able tolearn from the previous generation (of actors and of actions), they canquickly find themselves a step ahead of the institutional framework asthey knew it. Institutional frameworks may constrain, in other words,but they may also offer new possibilities as a result of these constraints,because they allow for forms of learning that may extend beyond thepossibilities recognized in the initial framework.

But the openness of institutional frameworks is, despite what radicalconstructivists seem to assert, not without limits. As Culpepper (2002)demonstrated, for example, without an adequate social and institu-

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tional infrastructure, it is impossible to construct high-skill trainingsystems de novo. Attempts in the 1970s by successive Labour andTory governments in the United Kingdom to forge a system of wagebargaining that helped check rampant inflation, failed largely becauseof the absence of underpinning institutions (Regini 1984). And as manycountries in Eastern Europe are finding out today, building the institu-tions of capitalism involves more than simply importing them fromabroad, especially if none of the necessary supporting institutionsare present. As we will see in the case studies in the next sectionof this chapter, institutions do set limits on the direction of poten-tial adjustment paths, even in extreme crisis situations. The initiallyhealthy reaction by the radical constructivists to the single-scenariodeterminism of the dominant institutionalist theories may thereforehave been an overreaction. Any notion of systemic institutional coher-ence (Aoki 2001; Hall and Soskice 2001) implies that particular pathsare excluded or impossible: institutions do offer ‘negative scenarios’.

The position we defend here builds directly on these criticisms andhas two components. The first is related to the underlying model ofchange. We think that the punctuated equilibrium metaphor which hasinvaded the analysis of change in political economy (and, to a lesserextent, economic sociology) over the last few decades (Krasner 1984)has led to a profound misunderstanding of processes of social, eco-nomic, and institutional change—a point noted early on, incidentally,in a famous essay by one of the ‘fathers’ of punctuated equilibriumtheory in biology (Gould 1980). Human society does not evolve accord-ing to a slow-speed Darwinian model in which multiple generationsare required to select small beneficial changes, and in which longperiods of stasis are interrupted by sudden sharp crises and rapidchanges. Instead it evolves according to a model that is closer to whatLamarck had in mind, in which traits acquired in one generation

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are transmitted to the next: human beings—and the social arte-facts they construct, such as interest groups, companies, and otherorganizations—learn, both across and within generations.2

This argument has two immediate implications. First, change, ratherthan the stasis invoked by the punctuated equilibrium models, charac-terizes human societies, and organizations, as actors are permanentlyevaluating their position and the returns on that position. In addition,and in large part as a result, change can be extremely fast in prin-ciple, probably limited only by the speed with which actors recognizethat a particular set-up does not serve their interests broadly defined.Institutional frameworks are therefore caught in an almost permanentprocess of redefinition, which allows actors operating within them toexplore interpretations that can be very different from the ones thatwere initially intended.

Second, while institutional frameworks may be considerably moremalleable and open than the conventional views assume, systemicconstraints of internal coherence impose limits on this openness. Thisappears to us as one of the most important lessons from the institution-alist analysis of comparative economic organization over the last twodecades. We leave open for the time being whether these systemic con-straints are best conceived of in terms of a tightly coupled system witha single-point equilibrium (Aoki 2001; Hall and Soskice 2001) or of alooser, Weberian-inspired ‘elective affinity’ model (Lane 1995; Whitley1999). What matters in our view is the emerging consensus in polit-ical economy and economic sociology that institutional cherry-pickingrarely works as planned, precisely because (to push that metaphor) thecherries are hanging on a tree that they need in order to grow.

In the next section we develop our argument through summaryaccounts of how large firms in France and Germany adjusted to dif-ferent pressures for change. In this process, as we will show, theinstitutional framework that they found themselves in acted as a con-straint by precluding particular options. At the same time, however,many of these firms managed to exploit endogenous but often hiddendegrees of freedom that the institutional framework offered. In thefirst account, on industrial renewal in France since the early 1980s, we

2 Note that we are not suggesting, as the literature on policy learning does, that this is anapolitical process. Learning can be of a purely didactic type, but almost certainly involves deeplypolitical processes: the construction of a problem, the inventory and development of resources(including power) at the disposal of protagonists, and the actual negotiations are an integralpart of what we call ‘learning’ in the Lamarckian sense. Jacoby (2000) develops some of thesearguments when discussing institutional transfer.

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will show not only that French policy-makers were unable to emulatethe German model which was the main signpost for their attempts torejuvenate French industry, but also that the ‘orphaned’ institutionsthat emerged as a result of these attempts, became the object of a pro-cess of active reinterpretation by large firms—the leaders, by default,in French industrial adjustment during that period.

The second summary discusses the introduction of shareholdervalue in Germany. Despite the very similar pressures to those thatoccurred in other countries, most notably in the Anglo-Saxon econom-ies in the 1980s, and which could have forced the corporate governancesystem in Germany down a similar path of rapidly expanding equitymarkets and outsider models of corporate governance, large firms inGermany adopted a model which carefully balanced workers’ andshareholders’ interests.

3.2. Surprising Reorganizations of Large Firmsin France and Germany

Methodologically, bothof theseaccounts canbe readas critical cases forthe view that institutional framework constrain actors in their searchfor solutions to new problems. The study of large firm adjustment inFrancehas tobe consideredagainst thebackgroundof the conventionalimages of the French business system, often dating back to Crozier’sseminal studies in the 1960s, which still inform much of today’seconomic sociology and political–economic analysis of the French eco-nomy. According to that view, French business is caught in a viciouscircle of low trust and therefore hierarchical workplaces, high stateinvolvement to overcome the problems that result from this workplaceset-up, and therefore anendemic incapacityof economicactors—firms,associations, and trade unions—to change without central state inter-vention. Imagine now that such a centralized state-centred frameworkis facing an increasingly competitive international economy and thatprotectionismno longer is aviablepolitical optionbecauseofEuropeanintegration. The outcome is, or ought to be, a profound crisis withoutan endogenous solution, precisely because the central state seems tobe the last actor to be able to provide that. Yet large firms in France notonly managed to adjust quite successfully; they did so without rely-ing on the state for guidance by exploiting the (perhaps limited butreal) existing degrees of freedom they discovered in their institutionalenvironment.

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The second case study is constructed in a parallel way. Germany’sinstitutional framework is considered to be highly restrictive in waysthat often remind us of the ‘stalemate society’ that France was sup-posed to be. As a result, when large firms became exposed to pressuresfrom international capital markets, large publicly quoted firms inGermany were facing several problems: the need to become moretransparent, construct compatible incentive structures throughout thecompany, and more attention to the demands of institutional investors.At the same time, however, the system of codetermination, whichgives workers and their representatives hard and soft participationrights in the companies, imposed hard constraints on how manage-ment could implement reforms that addressed their needs. Yet, theGerman codetermination system turned into an asset for corporategovernance reform, and the reforms themselves strengthened thecodetermination system because they imposed additional transpar-ency on the companies. The apparently overwhelming constraint inthis case study is the presence of several institutional constraints onthe ability of managers to conduct the business strategy of the firm.

Note, first of all, that the institutional frameworks for economicaction in these two cases have always been considered to be very dif-ferent in comparative analyses (Levy 1999: 23–56; Maurice et al. 1986;Ziegler 1997; Zysman 1977, 1983). Then consider the outcomes: inboth cases, the initial limits on the system imposed by the institu-tional frameworks restricted the nature of the options that large firmswere able to engage. In both cases, adjustment followed a path thatreflected the preexisting institutional framework. At the same time,however, the limits imposed by the institutional framework tell us littleabout the path actually adopted by the large firms in their adjustment,since in both cases the large firms reconfigured important elements intheir environment so that they became compatible with the types ofstrategic solutions they were searching for. Institutional frameworksmay have constrained the firms in their adjustment path, but they didnot condemn them to a particular form of adjustment.

3.2.1. The surprising modernization of French industry

By the early 1980s, the French economic development model, whichhadserved thecountrywellupuntil then (seeBoyer1997; Levy1999 forsuccinct accounts of the post-war French model), had ground to a halt.Economic growth slumped, inflation soared, productivity fell sharply,and corporate profitability followed suit. While it might be tempting

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to attribute this crisis to growing international competition which cre-ated competitiveness problems for the large firms, a closer look revealsthat the difficulties of the French model were the result of an internalcrisis of the French production regime, and exacerbated by the mac-roeconomic policies of the government between 1976 and 1983. Largefirms faced a dramatic productivity and profitability crisis, and themacroeconomic stabilization policies pursued by the Left governmentafter the U-turn in 1983 had two direct consequences for them. Itmade the ‘traditional’ French solution, which consisted of the statesubsidizing the companies out of the crisis, impossible because ofbudget constraints and European competition policy. Additionally, thetight monetary policies, which led to high interest rates in support ofthe franc, aggravated the financial problems of the highly indebtedlarge firms.

Between 1981 and 1984, French governments developed initiativesin three fields that were designed to support a forced reorganizationof French industry while allowing the broad macroeconomic policyto pay off in the areas of labour relations, regional development,and finance. Policy-makers were actively looking for inspiration inGermany, and attempted to copy what they considered as mature insti-tutions that critically contributed to German economic success ontoFrench soil. The Auroux laws, the largest package of labour reforms inFrench history, were meant to create an industrial relations system thatwould simultaneously defuse the perennial workplace conflict andmodernize the decision-making structures inside French companies.The Defferre reform package involved a series of measures that decent-ralized decision-making in many areas, one of which was economicdevelopment, towards the regions. The underlying aim was, with thestrength of local economies in Germany in mind, to build the condi-tions for similar dynamic local industrial tissues in different regions inFrance. Finally, the financial system was reorganized to make banksmore responsive to the needs of industry. Again, the German house-bank system, which involved close ties between banks and companies,served as an example.

This German-inspired road turned out to be impossible to adopt,and as a result the well-intended reforms ultimately failed to producethe results they envisioned. The Auroux reforms ended up weakeninginstead of strengthening the unions, and the workplace reforms thatdid come about were not only very modest judged by their initial goals,but became building blocks in a management strategy to increaselabour productivity. The decentralization of economic policy-making

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created a host of regional institutions for economic development, butwith very little effect on how local industrial structures were organ-ized. Finally, by rapidly introducing competition for both deposits andcredits, the financial reform not only weakened the (previously highlyprotected) French banking sector, it also failed to live up to its goalof bringing the worlds of finance and industry closer to one another.As Levy (1999) convincingly argues in a review of these different policyinitiatives, the reforms faced two types of problems: the first was thatthe actors that were supposed to be empowered by the new initiat-ives were too weak to carry them through on their own; the secondwas, ironically, that without the state, the actors that were supposed tobe empowered—the trade unions, the banks, and regional economicactors—were unable to use the decentralization policies. Since none ofthe supporting institutions were in place, the policies fell on very drysoil, and ultimately failed.

However, while the policies may have failed because they targetedthe wrong actors, large firms, through a process of trial and error,endedupdeploying themas tools for their ownrestructuring—therebyradically altering the meaning and impact of the policies and institu-tions in the process. In many cases, management in the large firmshad—or at least might have had—a reasonably clear idea about whereto go, but was incapable of envisioning ways to get there becausethe French institutional framework constrained most of their steps: in1984–85, at the apex of the crisis, the state was the outright owner ofa large part of the economy, indirectly controlled the bulk of indus-trial credit as a result of the nationalized banking sector, indirectly setwage rates for the economy through the minimum wage, and inducedstrategies of economic development through indicative planning.

Large firms in France therefore had to reorganize their ties withthe state, first and foremost the ownership patterns that linked themdirectly to the state—a process for which they relied on the newinstruments that were born out of the financial deregulation cumprivatization policies of the 1980s. In the nationalized companiesmanagement used the privatization policies to construct a corporategovernance system that acted as a protective shield against both apotentially intrusive state and potentially highly nervous short-termcapital markets. In the state-owned public services, the same wasachieved through permanent renegotiation of the relationship betweenmanagement and the state: stemming the losses of these companiesrequired a profound internal reorganization which emphasized prof-itability, and these (internal and external) goals were written into

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the planning contracts between state and management, leading toincreased operational autonomy of the latter. And in the private com-panies, management autonomy either never posed a problem, becausethe ownership and control structures provided management withthe autonomy for restructuring it needed; or structures that securedautonomy had to be created.3

After this redefinition of the relative position of managementvis-à-vis company owners, the second step was very similar in thedifferent large companies: they set goals for their internal reorganiza-tion, and attempted to adjust their workforce and supplier systemby introducing new organizational models that were slowly becom-ing standard organizational models in many other countries as well.Here, however, the old problems of the French model resurfacedunder a new guise. Neither workers nor suppliers had the capa-city to follow the companies in that new strategy. Many workerswere low-skilled, which endangered a productivity drive, the labourrelations system was conflictual rather than cooperative, and sup-pliers were technologically underdeveloped, organizationally weak,and underfinanced. The large firms squared the circle by relyingheavily on a wide collection of state policies that dealt with a reor-ganization of the labour market to restructure their workforce. At thesame time, they used the new institutions for local economic devel-opment to reorganize their supplier base: they enlisted municipaland regional development agencies, technology centres, training insti-tutes, and employment offices to support their suppliers in the forcedupgrade.

Thus, while the ‘German’ option of decentralized production thatrelied on workers’ skills, cooperative labour relations, deep competen-cies of suppliers, and an active involvement of banks in corporate gov-ernance turned out to be unfeasible because the underlying centralizedand adversarial institutional framework was unable to accommodatesuch a shift, French industry adjusted by finding its own route. Thelarge firms adjusted, not as a result of trajectories imposed by the state,but by actively constructing a new institutional environment that fittedwith what they perceived as their new needs, using these new tools tofurther their internal adjustment, and explore new markets. In orderto accomplish this, they borrowed elements from failed government

3 In some cases, this could take a long time and be subject to significant internal tensions whichfor a long time blocked any attempt at organizational restructuring and heavily burdened thefuture adjustment of the company, as in Moulinex (see Hancké 2002: Chapter 6).

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policies in the areas of corporate governance (to secure independencefrom the state and capital markets), and from decentralizing policies inlabour relations and economic planning (to support their productivitydrives). The French institutional framework of the 1980s may haveprecluded the preferred up-market option, but it also offered creativelarge firms instruments for their adjustment.

3.2.2. Corporate governance reform andcodetermination in Germany

The German system of corporate governance has been described asthe paradigm case of coordinated market economies in advancedcapitalism. The central institutions governing the German system,themselves tightly linked in a wider framework, included a concen-trated ownership structure with friendly domestic banks and firms atits core, a reliance on bank loans and retained earnings as a sourceof finance, accounting and disclosure standards that favour the accu-mulation of hidden reserves, and therefore do not accurately reflectmarket value, and a system of industrial relations characterized by theparticipation of employees at the firm level through codeterminationrights at the plant and board levels (Hall and Soskice 2001; Thelen1991; Zysman 1983).

The cosy world of German corporate governance was rockedby developments in the 1990s, both at the domestic and inter-national level, that significantly contributed to the rise of share-holder value as a key reference point for companies (compare Deeg,Chapter 2; Lane, Chapter 4, this volume). One critical driver wasprobably financial liberalization, which had two important con-sequences. On the one hand, it pushed up interest rates as bankswere forced to compete for deposits with new competitors; on theother, the use of derivatives and other exotic financial instrumentsexploded. The high cost of capital and the availability of alternat-ives encouraged large German companies to tap into internationalfinancial markets (Deeg 1999). In addition to financial liberaliza-tion, an increasing percentage of takeovers in the United States andin other advanced industrialized countries have been financed byequity swaps (Rappaport and Sirower 1999: 147–51), which impliesthat firms with a higher market capitalization possess a substantialadvantage in the global M&A marketplace (Coffee 1999: 649). At thesame time, the ownership structure of German companies evolved

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from one centered upon domestic banks and non-financial enter-prises to one in which financially committed institutional investorsbecame more important, which has increased substantial pressuresfor greater financial returns, and therefore put pressure on its systemof corporate governance—and of the position of employees within it(Hoepner 2001: 6).

The institutional framework that prevailed in Germany in the 1980sand 1990s, and the rights and position of works councils in the firmin particular, foreclosed the option of rapid and deep restructuringof large firms. While legal participation rights of works councils arestrong in social matters, weaker over personal issues, and modest ineconomic and financial matters (Müller-Jentsch 1995), they have beenable to use their veto power strategically in some areas through link-ing outcomes there to other issues where they have weaker rights. Theworks council at the Volkswagen’s Braunschweig plant, for example,used its codetermination rights on working times and wage gradesto demand an expansion of the skills and training funds for affectedworkers in the 1980s (Thelen 1991: 213). In addition, the positionof organized labour and the works councils in the training systemhas enabled them to impose significant constraints on hiring newpersonnel when a company scaled back its activities to a few corecompetencies: since new training programmes have to be approvedby an expert body in which organized labour holds half the seats, theyhave de facto veto power over these programmes.

While the existing institutional framework of German corporategovernance significantly limited the availability of options, and of atrajectory based on deregulation in particular, it also offered a seriesof possible adjustment paths. One possible outcome—often lamen-ted in the German and international business press—was immobilismas a result of the mutual veto positions of all the actors; a creat-ive reconfiguration of the institutions of the other. However, theGerman system of corporate governance has been characterized byconsiderable change. Some large companies have adopted elementsof shareholder value priorities in their strategy (Goyer 2003; Hoepner2001). Of all the changes in theGermansystemof corporategovernanceover the last decade, the adoption of financial transparency was per-haps the most important one (see Goyer 2003: 191–8). In 1996, only ninefirms of Germany’s largest 120 were using an international accountingstandard. By 2001 that figure had risen to ninety-six, and this figureincluded all the members of the DAX 30 stock market index. In con-trast, other measures usually associated with shareholder value, such

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as a focus on core business activities, have not become a new modelfor German firms.

The adoption of financial transparency as a strategy of share-holder value demonstrates the flexibility of the German institutionalframework. At their core, international accounting standards makeit close to impossible to accumulate hidden reserves, and as a res-ult reflect the market value of the firm better than the conventionalGerman standards. Moreover, quarterly reports force firms to provideplenty of additional information on a continual basis while makingcross-subsidies between units more visible. These effects protect theinterests of outside shareholders in the firm. But financial transparencyalso has the effect of increasing the information available to employees,especially in a ‘thick information’ setting like the German one—thusincreasing their ability to monitor management. It should thereforenot come as a surprise that employees have generally supported theintroduction of greater financial transparency (Hoepner 2001: 27).

This suggests that the institutions of corporate governance cancomplement each other in different ways under different conditions.The firm-level codetermination scheme found in Germany is perfectlycompatible with financial transparency under a shareholder value-oriented system—as it was under the previous bank-based financialsystem in which German accounting standards protected firms againstshort-term financial demands. Since the adoption of greater financialtransparency was a negotiated process with employee representatives(Hoepner 2001: 27–8), employees can act as informed and credibleparticipants in the process of firm adjustment, thereby reducing mana-gerial incentives to act in a unilateral manner. The active participationof employees in firm restructuring has allowed the institutions ofcodetermination to both resist the deregulatory consequences associ-ated with the advent of flexibility and of shareholder value strategies,and to turn them into instruments that reinforce existing employeerepresentation models.

Moreover, the negotiated adoption of some shareholder valuestrategies in Germany took place in an overall context in whichemployees have been able to shape the patterns of adjustment tochanges on world markets. In particular, the use of firm-level agree-ments has been a new element of the interaction between workscouncils and management in Germany. Works councils have alsoused their position to negotiate comprehensive restructuring pack-ages designed to allow for the introduction of shareholder valuemeasures without relying on wage cuts, dismissals, and external

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labour flexibility (Streeck 2001: 26). Over half of the 100 largest Germancompanies have negotiated ‘location agreement’ and ‘employmentpacts’, trading wages for job security, in the latter half of the 1990s.And slightly fewer than twenty of these have also included specificinvestment plans for the next 2–4 years in exchange for more flexiblework shifts and a reduction in company bonuses and wages. The aimof these plant agreements was to improve the competitiveness of firmsin a context of global competition, and they therefore make portfoliorestructuring through dismissals of workers in peripheral units a lessattractive option.

What lesson does the transformation of German corporate gov-ernance entail for the study of institutions? The German politicaleconomy—and its system of corporate governance in particular—

AQ: Pleasecheck. Streeck1992 ref. is notlisted.

has often been analysed as a mixture of constraints and incentives(Streeck 1992). The ability of management to implement strategiesof adjustment in a unilateral manner is constrained by severalfactors, most notably the legal rights of works councils and tradeunions. On the other hand, and in contrast to the arrangementsfound elsewhere, the institutional arrangements of German compan-ies provide management with opportunities to include employees inthe development and conduct of the business strategy of the firm(Thelen 1991).

While we agree with this view, we would emphasize that someof the enabling features of the German model are not related to theinstitutions per se, but result from experimenting and learning byactors. The various constraining elements of the German institutionalframework—barriers on dismissals, legal rights of works councils,training requirements, and others—could be introduced by legislationin other countries. By contrast, only some of the enabling arrangementsof the German system—such as associational governance of trainingor the inability of firms to poach skilled workers—could be copied vialegislation.

For example, in many large firms works councils have used theirlegal rights to become de facto comanagers of the firm, and therebyhave often been key actors in the introduction of competitiveness-enhancing rationalization schemes (Herrigel and Wittke, Chapter 11,this volume; Müller-Jentsch 1995). The willingness of works councilsto become positively involved in the business strategy of the firmreflects the choices and strategies of actors in light of two keydevelopments. The first is the decentralization of wage bargainingin Germany—and the rise in importance of several new firm-level

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issues—has increased the importance of works councils at the expenseof national unions. However, the decentralization of wage bargain-ing is not unique to Germany, and its consequences on the behaviourof works councils differ across nations as the French and Swedishcases demonstrate (Howell 1992; Thelen 1993). In these two coun-tries, the weakness of firm-level works councils entailed that thedecentralization of wage bargaining meant that either trade unionsfaced a major identity crisis that required fundamental institutionalchanges (Sweden) or that firm-level flexibility came to be associatedwith straightforward deregulation of the labour market (France). Thedecentralization of wage bargaining and the rise of importance of firm-level issues, however, cannot by themselves account for the strategyand actions of works councils in Germany.

The second development is the negotiated introduction of share-holder value strategies in Germany—but which is not unique to thefield of corporate governance. Economic adjustment over the lastfifteen years has often been framed by negotiations between employ-ees and management at the national level. One can point to thetripartite committee on the Alliance for Jobs and the process of socialconcertation as embodied in social pacts as prime examples of thenegotiated adjustment of the German political economy (Regini 2000).Package deals linking issues across several policy fields—employmentand social policies, wage bargaining, welfare reform—have been themain outcome of these negotiations.4

The negotiated character of changes in German corporate gov-ernance and other policy areas accounts for the willingness of workscouncils to become active participants in the strategy of the firm,since it has provided employees with the ability to act as informedand credible participants in the process of firm adjustment, therebyreducing managerial incentives to act in a unilateral manner. Theactive participation of employees in firm restructuring has led to asituation without the potentially deregulatory consequences associ-ated with the advent of flexibility and of shareholder value strategies.Codetermination therefore seems to have evolved from a set of insti-tutions designed to reconcile class conflict into a framework in whichthe competitiveness requirements are internalized in part by the abil-ity of works councils to act as a strategic partner for management(Hoepner 2001).

4 See also the above discussion on the introduction of firm-level agreements on location andemployment in Germany.

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3.3. Conclusion

This chapter has argued that the dominant view of institutions in con-temporary political economy increasingly seems to miss importantdynamic elements of economic change. Most importantly the view ofchange associated with this approach—path dependency—is unableto make proper sense of two disturbing elements. The first is how toanalyse the coexistence of different organizational patterns within onenational economy. In essence, the dominant views define those awayas statistical noise. The second was how to make sense of possibleadjustment paths that were ‘not chosen’—were they the result of thefeedback mechanisms at the basis of the path-dependency view? Bothproblems follow from an inadequate conceptualization of the inter-action between institutional frameworks and actors that underlies thedominant view.

The two summaries of corporate adjustment in France and Germanyover the last two decades demonstrated the need for a view that treatedinstitutions not simply as constraints under which actors optimizeadjustment paths. Rather than simply imposing constraints, as wedemonstrated, institutional frameworks also provide elements thatactors can creatively use to build responses to new challenges. In thecase of large firm adjustment in France, the initial road, inspired by theinstitutions that were associated with German economic success, wasimpossible because many of the underlying arrangements found inGermany were simply not present in France. But, instead of beingtrapped in this situation, firms then began to actively construct anew institutional framework, with elements of existing old and newpolicies and institutions that met their needs. Similarly, instead ofbeing caught in the maelstrom of shareholder value, which supposedlypits managers and owners against workers, the codeterminationsystem in Germany became a crucial institutional vehicle for managingexternal pressures.

This suggests that institutions embody multiple potential scripts.Historical institutionalism seems to (and, in all fairness, often does)give convincing ex post explanations for why one of these scripts pre-vailed. However, it is frequently unclear if two conditions held: werethere real alternatives that were actively debated, and did the ulti-mate choice follow from the rational calculus of actors? Explainingwhy some options were not chosen is therefore equally important aswhy some were chosen; the burden of proof is—especially in the caseof historical continuity—as much on ‘why not?’ as on ‘why’.

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This is not a call for establishing counterfactual histories, or fordisappearing down a methodological black hole in trying to answerthe usually overdetermined question of why something did nothappen (Emigh 1997). What we suggest is that explaining institu-tional continuity—perhaps especially continuity—resulting from pathdependency requires more careful research designs, often of a com-parative nature, to demonstrate how choices were made, and thatthese choices reflected the rational calculus mechanisms at the basis ofpath-dependency arguments.

But the path-dependency arguments have made a few importantmethodological and theoretical contributions, to which we shouldremain attentive. The chances for success of institutional changeor reform are not distributed symmetrically. It is, for example,much easier to actively deregulate a labour market (as Thatcherand Reagan demonstrated in the 1980s), than to build a new, non-market based, institutional framework (as the French discovered—seeCulpepper 2002). Similarly, some piecemeal reforms of elements ininstitutional frameworks might be simply impossible because theyare inconsistent with other elements in the framework. Even in itsweakest version, institutional complementarities impose a degree ofinstitutional congruence that cannot simply be ignored.5

As a result, some adjustment paths may be impossible—the Frenchpolitical economy, for example, may have had many options open, butthe German road that policy-makers aspired to was definitely not oneof them (Culpepper 2001; Hancké 2002; Levy 1999). However, identify-ing what is impossible says little about what is possible. This is wherethe limits of the historical–institutionalist approach, as exemplifiedin the path-dependency argument, become apparent.

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